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14 Jul 2021

How to handle inflation.

Strategy Avoid knee-jerk changes but be prepared for sustained price rises that could deflate your buying power and real wealth, writes Tony Featherstone AFR weekend Smart Investor 12-13 June 2021
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As COVID-19 sparks fears of higher prices, investors face their biggest question in decades: is the era of low inflation ending sooner than markets expect?

The answer to that trillion-dollar question could define asset returns for years. Investors on the wrong side of a price outbreak would be hurt by larger negative real returns (after inflation) on cash and government bonds. Sharemarkets would fall.

Markets braced for Thursday’s news on US inflation for May. Investors needed to know if April’s horror inflation result was a pandemic-related aberration or the start of sharply higher prices – and a faster timetable for interest-rate rises than central banks expect.

The data was mixed. US consumer prices surged 5 per cent in May from a year ago – the biggest increase in nearly 13 years. But Wall Street shrugged off the slightly-higher-than-expected result, believing price rises in vehicles, travel, apparel and other key components are temporary and due to coronavirus-related supply bottlenecks.

That result won’t deter inflation hawks who believe the world is on the cusp of 1970s-style inflation. They argue massive increases in government spending and ultra-loose monetary policy will drive demand too high, when COVID-19 is disrupting supply of raw materials and labour.

The hawks point to soaring prices this year for iron ore, copper, lumber and some soft commodities – as well as reports of US firms lifting wages to attract staff.

For now, the consensus view on inflation is still more dovish. Prices will rise temporarily rather than permanently. As COVID-19 vaccines roll out, supply chains will eventually unclog and more people will return to work. Price pressures will abate.

The inflation debate is delicately balanced. Nobody suggests making knee-jerk portfolio changes based on inflation speculation. But investors should be prepared. A sustained spark of higher-than-expected inflation could set fire to some asset prices.

“Where inflation settles after COVID-19 has profound implications for asset prices,” says Emma Fisher, a portfolio manager at Airlie Funds Management. “Inflation will definitely increase in the next 12 months. Every company we talk to says it is seeing greater cost pressures.

“The question is whether higher inflation becomes a multi-year story for markets. My sense is it won’t, principally because of the amount of global debt which acts as a deflationary force by making it harder for central banks to raise interest rates by as much as in previous cycles.

“But it’s too soon to know how inflation will play out after COVID-19. When investors are faced with an ‘I don’t know’ moment, the best approach is ensuring your portfolio can cope with different outcomes. You need a bet each way on inflation and to be ready to move quickly.”

While inflation debates can seem esoteric for retail investors, that’s not the case for retirees. Living on fixed incomes and with a large part of their savings in cash and government bonds, rising inflation rapidly erodes their purchasing power.

Wealth accumulators are also affected. Information technology and utilities are the worst-performing stocks in the S&P/ASX 200 index this calendar year, down 12 per cent and almost 10 per cent respectively to end-May 2021, S&P data shows.

Higher inflation expectations and rising bond yields have prompted a switch from growth stocks, such tech companies, to value stocks. Interest-rate-sensitive sectors, such as utilities, infrastructure and listed real estate, have underperformed the S&P/ASX 200 this year.

Fortlake Asset Management founder Christian Baylis says the big unknown is how long it takes for production-supply bottlenecks to unwind during COVID-19. Baylis has studied inflation for years – first through his PhD research on inflation modelling and then in funds management with UBS and now Fortlake.

“COVID-19 has created a once-in-a-generation wipe-out of excess inventory in the world, and allowed inflation to get on the front foot,” he says.

“When borders are shut, inventory is not easily replenished and less-efficient countries fill the void, resulting in higher-cost production. Countries have to find new sources of raw materials or labour for markets where there is strong demand. If these bottlenecks take longer than expected to fix, consumers will start to adjust their price expectations higher.”

Baylis does not expect a large inflation outbreak but warns that the risk of higher inflation for longer is rising. “Real interest rates (after inflation) could go deeply negative in Australia in the next 12 months and particularly so for those less-efficient countries. Investors could face negative 2-4 per cent returns on short-dated securities if inflation picks up beyond the RBA target (2-3 per cent, on average).”

Baylis says investors should protect their portfolio against the threat of higher inflation. Fortlake’s bond funds continue to hedge against inflation risk – a strategy that has helped the firm deliver strong returns this calendar year and attract more than half a billion dollars in funds.

The key, says Baylis, is dealing with inflation uncertainty due to so many unknowns with COVID-19, such as virus mutation. “It’s impossible to forecast what will happen to inflation during and after COVID-19 because nobody knows for sure how the pandemic will end.”

The inflation debate went into overdrive last month after a shock result in the US. Inflation leapt to 4.2 per cent over the year to April – the fastest increase since 2008. That prompted talk of higher interest rates to cool the US recovery, something equity markets hate.

Australian investors have had a charmed run with inflation. After peaking at 17.7 per cent in March 1975, the consumer price index has been in long-term descent. It has mostly hovered between 1-2 per cent since 2015, enabling interest rates to fall to record lows. Cheap debt has put a rocket under house and share prices in the past 12 months.

In its latest monetary-policy decision, the Reserve Bank of Australia said it expects “subdued” inflation and wages pressure, despite Australia’s strong economic recovery. “While a pick up in inflation and wages growth is expected, it is likely to be only gradual and modest,” said RBA governor Philip Lowe.

The RBA’s central case is underlying inflation of 1.5 per cent in 2021, rising to 2 per cent in mid-2023. CPI inflation could jump above 3 per cent in the June 2021 quarter (from 1.1 per cent in the March quarter), but the rise will be temporary and COVID-19 related.

That’s a big bet. Some experts believe price pressures are building faster than central banks realise. Billionaire US investor Sam Zell last month bought more gold to protect against higher inflation (he has rarely bought gold). Known for his knack of timing markets, Zell saw inflation “all over the place” and said supply bottlenecks were “very reminiscent of the 1970s”.

Wall Street legends Warren Buffett and Stanley Druckenmiller have also sounded the alarm on rising cost pressures in the US. The prominent American economist, Stephen Roach, said central banks’ dismissal of higher inflation was “cavalier” and a gamble “in a league of its own”.

Back home, Fat Prophets founder Angus Geddes is also worried about inflation. “Higher inflation will be far from temporary – it’s going to heat up. Commodity prices will stay elevated for longer than central banks expect. Decades of low inflation cannot last forever. The inflation cycle is turning higher. That’s a massive change investors must prepare for.”

Inflation comparisons between the 1970s and today attract headlines. But central banks did not target inflation back then in the same way they do today or have a defined, acceptable level of inflation (the RBA adopted inflation targeting in 1993). And unions were more powerful in the 1970s and better able to push for wage rises that add to cost pressures.

Also, the current great deflationary forces – globalisation, technology and debt – were less pronounced in the 1970s. Of course, rampant government money printing, a feature now, has always ended badly in the past. But COVID-19 could be deflationary in the medium term if the uptake of online commerce quickens, and if some knowledge workers accept the same or slightly lower wages in return for greater workplace flexibility.

Vihari Ross, head of research and a portfolio manager at Magellan Financial Group, says investors should distinguish between short- and long-term inflation trends. “Governments have effectively shut their economies to keep their community safe during COVID-19 . They’ve artificially constrained supply and boosted demand. It’s completely unsurprising that we’re getting inflation.

“Longer term, there is nothing to suggest the big deflationary forces are abating. There has been no shift in worker productivity or built-in wage pressures. Companies are still using technology to provide more value in products for the same or lower cost. And the world remains awash with debt that has brought forward years of consumption. As such, we think higher inflation is ultimately a temporary rather than structural phenomenon.”

Ross says investors who can look through higher inflation in the short term should focus on companies that have been sold off. “Some of the big tech companies, fintechs, enterprise software providers and online platforms are starting to show value. So, too, are some utilities and consumer staples stocks that have de-rated due to inflation concerns.”

In theory, investors betting on higher inflation should increase their portfolio’s gold-bullion allocation and favour inflation-linked or floating-rate bonds. Among stocks, they could buy resource companies that gain from elevated commodity prices or banks that have higher net interest margins when long-term bond yields rise.

Investors who agree with the RBA’s view of gradual inflation rises could pounce on the sell-off in growth stocks. Ironically, quality tech companies are among the best placed to withstand rising inflation because they can pass on higher prices without destroying customer demand.

The key for investors is asking the right questions about inflation, even if nobody has the answers just yet. Will I have enough real income if inflation returns to 3 per cent and stays there? Does my portfolio have sufficient protection if inflation is higher than expected? And how can I capitalise on uncertainty by buying stocks that are oversold due to inflation fears?